Guest Viewpoint: Peter Kraneveld – International Pensions Adviser

“Let’s stop using the term de-risking altogether and use the right words for what we are doing”

It sounds quite positive. De-risking. I am not aware of any research on how the word is perceived by pension beneficiaries. My best guess is that it is understood as something like ‘they discovered a new technique to take the risk out of pensions’. That’s not even totally wrong, as long as you don’t ask whose risk is diminished.

The inconvenient truth, as a politician might put it, is that there is a relation between risk and return. Increase risk and return goes up. Decrease risk and return goes down. Take no risk and there is no return; capital is eroded by inflation. In other words, risk is the necessary evil you must accept to get a return. Risk manifests itself as fluctuation: investments get to be worth more or less temporarily. That can be nerve-wracking, but in the end, the upward swings and downward swings mean little. Investors refer to them as ‘hot air’. Risk is not lethal to pensions. Rather, it is a necessary building block of pension capital.

How important is return? The easy answer is that it’s different for different pension funds. True, but neither informative nor helpful. Let’s use an example to get a better answer. John Smith earns €100,000 a year and pays 10% into a pension pot that earns a return of 4% annually net of cost. He starts working when he is 28 and retires when he 63, a total of 35 years. At the end of that period, Mr Smith has accumulated a pension capital of €766,000. Of that, €350,000 is his own savings and €416,000 is return. In other words, 54% of his pension capital is return. 

When he retires, Mr Smith no longer pays into his pension fund, but he can keep his pension capital working for him. If he succeeds in finding an annuity with a similar return, he will find that the total of his pension capital during his lifetime may contain 70% return or more. If his pension fund distributes the pension, return may tend towards 80% of capital.

Unsurprisingly, a lower return has a large effect on Mr Smith’s pension capital. If the pension fund de-risks, bringing returns down to 2%, Mr Smith accumulates just under €510,000 when he is 63. He loses a third of his pension capital when he retires. The risk of the investment has been lower. If Mr Smith had a pure DB pension, lower risk was a benefit for his employer. If his fund was pure DC, he received lower risk himself. If that is what he explicitly wanted, he paid the right price for his wish. Otherwise, he loses out for lack of knowledge. Let’s improve his knowledge and call things by their proper name – de-risking is lowering pensions.

That said, lowering risk may be exactly what is called for. Not long ago, portfolios were (too) heavy on equity, (too) light on bonds. When that is realised, it is sensible and warranted to change the portfolio. That indeed lowers risk, but in today’s circumstances, it may also increase returns. The interests of the beneficiaries prevail. And yet, there is a ‘but’. De-risking in this sense is a two-way street. If the circumstances change again, the portfolio should change again also. Of course, pension funds could be fashionable and call that re-risking. However, that sounds as bad as de-risking sounds good, so they may not be willing to call it by that name. 

Once again, de-risking falls short of transparency and honesty. Adapting the portfolio to different economic circumstances has traditionally been known as portfolio management. Using that term instead of de-risking gives an adequate and truthful idea of what is going on. 

We live in an age of shameless marketeering, where lying and misleading has become acceptable in the framework of selling products and giving even part of the truth requires lethal products like tobacco and hard government regulation. Does it matter if the consumer is told one more lie? If he never realises he’s being lied to, is it important? I think it is. 

“Risk is not lethal to pensions. Rather, it is a necessary building block of pension capital”

The pension sector is not an industry. Pensions are not a product. Pensions are a social service that people need, to survive in dignity at old age. Pension funds use the financial industry to achieve their goals, just like hospitals, universities and armies use commercial products to get their job done as efficiently as possible. Would you accept lies about medical care, the value of educational diplomas or the reasons to go to war? History, even recent history, suggests not. Lying about pensions is on the same magnitude of wrongness. Transparency and good communication are central and crucial to pensions. Throughout Europe, pension funds are harangued about it, not just by their own beneficiaries, but also by pension fund supervisors and the media. 

The critics have an excellent point. Lying undermines trust in the pension sector and trust is the basis for asking people to relinquish control over their money for decades. Mr Smith parted with the money he earned himself with his own work for an average of 17.5 years, trusting that his pension fund would act in his best interest. When that trust is shaken, it undermines pension funds’ right to exist. It could throw Mr Smith back on his own devices. There is a solid body of scientific evidence that shows he would be even worse off taking his own investment decisions.

Pension funds could probably live very well with calling portfolio management just that. Calling de-risking lowering pensions will meet with quite a bit of resistance, but the pill can be sweetened. The first step would be to analyse a change in expected pensions, dividing it in three portions. One portion would be financial market risk and the fund’s cost. This is the responsibility of the pension fund. The leadership of the pension fund should take full credit or blame for it. It is up to them to explain the function of risk on financial markets to their beneficiaries.

The second portion is changes in the law, whether national or European. These changes are the responsibility of democratically elected politicians. The consequences of these changes should therefore land in the laps of voters. Pension funds should explain the changes in the law and the consequences, and charge those consequences against pensions immediately. They should not be ‘compensated’ or be otherwise hidden.

The third portion concerns changes in the pension ‘deal’. They are the responsibility of the labour contract partners, employers and employees. Pension funds should spell out the changes and their consequences as well as the division of power between the labour contract partners. Funds should not want to explain the changes, referring questions and comments to those responsible. Explaining and answering would be up to the labour contract partners.

This analysis is practically possible. It would not be very different from an asset-liability management (ALM) study and it could probably use the modelling and data used for the current ALM study. The analysis would divide the responsibility in an honest way and let every pension stakeholder do his own explaining.

When one of his pupils asked Buddha what would be his first action if he were king, the answer was “clarifying words”. To Buddha, honesty and transparency were primordial. So let’s stop using the term de-risking altogether and use the right words and procedures for what we are doing. It can only improve our sleep.